3/18/2010 @ 12:01AM

A China-U.S. Reckoning

The fault lines in the U.S.-China relationship have been increasingly exposed in recent weeks, with rhetorical barbs exchanged on: trade; the treatment of foreign companies in China; strategic issues such as U.S. support of Taiwan and Tibet’s Dalai Lama; responses to Iran’s nuclear ambitions; and especially exchange rates. Domestic consensus in the U.S. on the need for action with regard to the renminbi (RMB) is growing. Chinese leaders, including Premier Wen Jiabao, have recently hit back at the U.S. for what they characterize as interference in China’s security and economic affairs, and U.S. economic mismanagement.

Today we examine the quest for the new normal between the world’s largest creditor and its largest debtor. Given the importance of the relationship to global trade, growth and security, we believe that the two countries will avoid a full-blown confrontation, but uncertain relations and tit-for-tat trade policies could constrain global growth.

The friction suddenly afflicting the world’s most-watched bilateral relationship stems from a struggle on the part of both China and the U.S. to deal with the changing dynamics of global economic and political power and influence since the financial crisis. To some extent the financial crisis exacerbated ongoing structural changes that had elevated the role of emerging markets in the global economy and increased their influence in debates on financial regulation, trade and currency policy.

China’s ample resources, together with its ability to encourage its banks to lend and its state-owned enterprises to spend, also allowed it to be opportunistic, adding sharply to its resource holdings and supporting cash-strapped countries and companies during the recession. Yet its leverage on U.S. policy seems overstated, particularly as China’s willingness to diversify away from U.S. assets remains constrained by its desire for a stable economic policy. Moreover, its economic apparatus is stronger than its security position. In this environment, there is a risk that one or the other player might overplay its hand or badly misinterpret the intentions of the other.

The pressure for bilateral and multilateral cooperation, which helped stave off a near-depression in 2009, has diminished. Given the role of the U.S. and China in sparking–and ultimately easing–the crisis, it was no surprise that bilateral tensions would be suppressed during this period as both countries looked inward to support growth. China, and to a lesser extent some other emerging market economies, have not yet fully embraced the economic and political multilateral policy initiatives that will help mediate the global economic order. By the same token, existing global institutions still do not reflect some of these changes. The G20′s rise to prominence does provide a potential venue for negotiation, but it remains too large and diverse to be efficient, and many different policy goals have been thrust onto its agenda.

Although political tensions appear to have heightened after December’s Copenhagen climate change meeting–in part due to the American perception that China’s behavior prevented a more ambitious agreement on carbon emissions from taking shape–at least some of the recent friction seems designed to play to the U.S.’ and China’s respective domestic constituencies. The U.S sells weapons to Taiwan, and China threatens sanctions on U.S. defense contractors; President Obama meets with the Dalai Lama, and China cancels bilateral military parleys. Meanwhile, both cry foul with respect to the other’s economic policies in their legislative meetings.

The lull in the cycle of diplomatic summits and visits since the Copenhagen meeting have contributed to the falling out. But the diplomatic cycle picks up again in April, with President Hu Jintao expected to attend an April summit on nuclear proliferation in Washington, while U.S. officials prepare for the next round of the U.S.-China Strategic and Economic Dialogue scheduled for this summer in Beijing, as well as upcoming G20 meetings. Each side will probe for new sources of leverage, and further chiding in public may be inevitable.

Still, the past several months have revealed some dangerous misperceptions. Last year the Obama administration pushed for China’s cooperation on a global climate change deal, but expectations that China would ever sign a binding emissions deal that might slow its economic growth seemed optimistic at best. Recently, China appears to have pressed U.S. diplomats to foreswear future weapons sales to Taiwan in return for cooperation on Iran, a position the administration could not legally take. Neither side is likely to seriously overplay its hand in 2010, but the risk is that in areas where contact is infrequent and superficial–like military-to-military ties–one side may adopt policies or postures that inadvertently provoke the other.

The first year of the Obama administration saw diplomatic exchanges increase across the board, with rather dramatic results on some under-the-radar issues like clean tech. While each side has taken the recent lull in diplomatic exchanges to recalibrate, the resumption of these exchanges may struggle under the burden of recent tensions. Meanwhile, other U.S. allies, ranging from Australia to the Europeans, seem to be calling on the U.S. to retain its firm position with China, a message that may pervade President Obama’s upcoming Asia trip.

The tit-for-tat trade tensions seem fated to continue simmering into 2011, given subdued global trade growth, but it’s unlikely that the U.S. will declare its second-largest trading partner a currency manipulator, which would set in motion an economic and political response. China will drag its feet on Iranian sanctions, but ultimately it is not in a position to block any deal on Iran’s nuclear program if Russia is really on board. Yet in the medium-term the coincident political cycle in the U.S., China and Taiwan could prove dangerous, with each country holding presidential elections (or, in China’s case, a Communist Party leadership succession) in 2012.

Nouriel Roubini, a professor at the Stern Business School at New York University and chairman of Roubini Global Economics (RGE), writes a weekly column for Forbes. Rachel Ziemba is a senior research analyst and Adam Towle is a research analyst at RGE.